Is the re/insurance industry really prepared for a large tail event?

It’s been questioned whether the insurance and reinsurance sector is ready for a significant tail event that could cause losses of $150 billion or more, or if the industry is too focused on being ready for the next Katrina.

For the first time since 1851 the state of Florida has gone a decade without a landfalling hurricane, and while the insurance and reinsurance industry is prepared for the next Katrina in terms of capital adequacy, events “deep in the tail” are what the industry should pay more attention too, according to Risk Management Solutions (RMS) co-founder and Chief Executive Officer (CEO), Hemant Shah.

“I worry more about our focus on events like Katrina, our tail is very long. When we simulate events, Katrina is not the 100-year loss in the U.S. We simulate events across perils that could cause well in excess of $100 billion in loss, and I think that is the kind of event the industry should be more mindful of, events deep in the tail,” explains Shah.

A consistent inflow of reinsurance capital from both traditional and increasingly alternative sources, as well as the ongoing benign catastrophe loss landscape, has bolstered the market’s overall capitalisation in recent times.

And while the current market sits awash with capacity, resulting in a supply/demand imbalance that continues to pressure rates for both reinsurance and increasingly primary players, it’s expected the sector could absorb a 1-in-100 or 1-in-250 loss event.

Shah, however, feels there “is often too much focus on the 1-in-100 or the 1-in-250” event, and believes the industry needs to look deep into the tail, where “there are some scary events.”

Speaking with A.M. Best, Shah underlined that a $150 billion hurricane along the U.S. East coast, a West coast quake, or a huge earthquake in the New Madrid seismic zone, has the potential to “cause significantly more losses than we’re accustomed to thinking about in the Katrina scale.”

Unprecedented, or very significant catastrophe events with a low-frequency probability but extremely high loss potential can cripple companies, societies and economies. And while the likelihood of such an event is low, re/insurers would be wise to pay more attention to losses of this nature than is currently evident, says Shah.

As the risk moves further down the tail the probability of the event occurring declines, as the loss potential and severity of the catastrophe rises. The further down the tail the risk is, should also mean lower expected losses and attachment points for insurance-linked securities (ILS) structures such as catastrophe bonds.

As a result of this, the issuance of catastrophe bonds, or similar insurance or reinsurance-linked structures to protect against tail risk events could be cheaper to issue, and relatively easy to receive adequate investor interest.

While ILS investors are keen to acquire higher coupon notes from catastrophe bond issues, there are many large, institutional investors that would appreciate a chance to allocate capital to lower return, more remote risk issuances.

So beyond being mindful of the tail risk events, insurers and reinsurers could, and perhaps should consider the use of ILS or catastrophe bond protection to cover such exposures. It could be very cost-effective protection, leveraging the capital markets for hedging the risk of tail catastrophe events, which is exactly why the catastrophe bond market came into being around 20 years ago.

Securing tail risk protection from the capital markets could serve to increase re/insurance companies overall capital adequacy, enabling them to shift capital around at different times to ensure sufficient capacity is available for underwriting the more frequent, but lower severity events.

As the reinsurance and insurance industry is increasingly disrupted by new and lower-cost forms of capital, the balance-sheet is best put to use on underwriting the frequency type events, while the capital markets may be the best home for the tail exposures. Utilising catastrophe bonds for tail risk could enable re/insurers to better focus on putting their own capital to work more efficiently and for better return on equity (ROE).

As with so many risks in the world today, it’s unlikely the insurance and reinsurance sector alone has the capital to adequately protect individual firms and the market as a whole from tail risk events, and instead will need the structures, willingness and capacity of the capital markets and ILS investors.